Globalization and Wages

∗
Prof. Dr. Wilhelm Kohler
University of Tuebingen

BSc in International Economics

BSc in Economics and Business Administration
BSc in International Business Administration

Summer Term 2019

∗
This is for use only by enrolled students of the above programs. Highly provi-
sional and with references (in concise form) to literature listed in the syllabus which
is available under ILIAS as well as on my homepage under http://www.wiwi.uni-
tuebingen.de/lehrstuehle/volkswirtschaftslehre/international-economics/teaching/ss-
2018.html Please do not quote.

1
W. Kohler, Univ. of Tuebingen, “Globalization & Wages”, SS 2019 2

Overview (tentative):

1. Introduction

(a) Focus
(b) Some numbers
(c) Perspectives on income inequality

2. Trade and wages: standard theory

(a) Factor endowments: Heckscher-Ohlin

i. Two dimensions
ii. Many dimensions
(b) Specific factors: Ricardo-Viner
(c) Task trade

3. Labor market effects of trade: empirical approaches

(a) Wage effects of trade liberalization in Ricardo Viner economies

(b) Labor market effects of trade exposure
i. A regional approach
ii. Looking at individual workers
(c) Labor market effects of offshoring

4. Gains from migration

(a) The immigration surplus

(b) Brain drain and brain gain from emigration

5. Wage effects of immigration

(a) The area approach

(b) A structural approach

6. Summary and Conclusion

W. Kohler, Univ. of Tuebingen, “Globalization & Wages”, SS 2019 3

1 Introduction

1.1 Focus
• General observation: trend over the past 3 decades:

– Increase in economic globalization among almost all countries (al-

though with different extent and speed)
– Concurrent trend: Increase in within country inequality (among
most countries, if not all)

• Public debate often interprets causality into this observation: global-

ization causes inequality

• But concurrent trends do not establish causality!

• Two approaches:

– Use statistical methods to establish empirical causality

– Use theory to identify possible mechanisms through which global-
ization might affect inequality

• Not strict alternatives:

– If statistical analysis suggests causation, we still need to know

about the mechanisms involved
– If theory identifies certain mechanisms, we still need to know how
important they are empirically

• Clear a priori: globalization will hardly be the only determinant of

inequality, the second suspect as an explanatory factor of inequality is
technological change

• Conventional (textbook) trade theory emphasizes “gains from trade” :

– Assumes representative households (ruling out all inequality)

=⇒ if trade is beneficial, all individuals gain equally from trade
(trade cannot increase inequality)
W. Kohler, Univ. of Tuebingen, “Globalization & Wages”, SS 2019 4

– Or else (if households are different): inequality effects possible,

but one invokes costless lump-sum redistribution (compensation)
mechanism
– Speaks of gains from trade for economy at large, if losers can be
compensated (by income transfers) without having to take away
all real income gains from winners (Pareto improvement)

• Important distinction regarding the focus (type of comparison, or sce-

nario):

– Present situation (with trade) versus hypothetical case of autarky

- trade effects
– Present situation with restricted trade versus alternative situa-
tion according some policy proposal, with less restrictions (lower
tariffs, say) - trade liberalization effects

• In either case: counterfactual analysis - including unobservable situa-

tions
• Globalization is more than trade: migration and capital movements

– Above compensation argument becomes trickier, if people move

internationally: how should we define the population when check-
ing possibility of Pareto improvement?
– Standard approach: Look only at group of natives in immigration
country

• The most recent World Trade Report 2017 by the WTO is concentrat-
ing on the labor market effects of trade and technology:
https://www.wto.org/english/res e/reser e/wtr e.htm (again, available
free of charge from UT IP address). This contains valuable empirical
information as well as conceptual and analytical views on the subject.
We shall repeatedly draw on this report below.

1.2 Perspectives on income inequality

• People are born different (innate differences in abilities and tastes) =⇒
they end up doing different things to earn income:
W. Kohler, Univ. of Tuebingen, “Globalization & Wages”, SS 2019 5

– They undertake different levels of effort to become educated, ac-

quire skills
– Even for given level of educational effort, different people acquire
different types of skills
– Subsequent to education, different people work for different firms
(or establish firms) in different industries
– Different people take different jobs (do different tasks) within a
firm

• At any point in time, looking at a (regional or national) economy, or

even the world economy, we find people earning (vastly) different real
incomes =⇒ inequality

• Any exogenous “shock”, or exogenous trend will affect people’s real

income differently – inequality changes over time

• Key distinction: functional vs. personal income distribution

– Functional: between different types of incomes (labor vs. capital,

different types of labor income)
– Personal: between different people
– Difference if each person earns several types of income

• Further distinction:

– Inequality explained by different individual abilities and charac-

teristics as workers (age, experience etc.)
– Residual inequality: inequality not explained by the above

• Policy issue:

– A key question is to what extent this inequality in incomes simply

mirror inequality in the above mentioned dimensions, particularly
regarding skills
W. Kohler, Univ. of Tuebingen, “Globalization & Wages”, SS 2019 6

– But even if it mirrors skill heterogeneity among individuals the

policy question is whether we are willing to accept this inequality,
maybe even welcome it for incentive reasons, or whether we look
at it as a problem to be dealt with (towards achieving greater
equality) by certain policy instruments
– It may sound a bit far-fetched, but in principle the policy prob-
lem might also be the opposite: not enough inequality (equality
of incomes despite different skills, effort levels etc.), so that soci-
ety needs a policy undertaking to establish more inequality. Ob-
viously, against the backdrop of the present policy debate, this
seems very odd.

• Intuition: income earned by individual with certain abilities and in

certain capacity (i.e., types of workers) depends on

– demand for those workers and

– supply of those workers

• These demands and supplies make certain individuals relatively scarce

in a certain economy/region, and others relatively abundant
• In addition to individuals’ abilities as workers, what matters is the
demand and supply of capital (different types of capital)
• In economics, scarcity feeds into equilibrium prices (i.e., wages) for
different types of workers and capital =⇒ inequality of incomes
• But demand for such factors of production (workers, capital) is always
demand for production of goods, hence income inequality is ultimately
driven by demand for certain types of goods and supply of factors
required for production of those goods
• And it is here where globalization comes in:

– In a closed economy it’s domestic demand for goods and domestic

supply of factors that matters
– In an open economy domestic demand for goods may also be sat-
isfied by imports from world goods markets and demand for do-
mestic factors may come from world demand for domestic goods,
i.e. exports
W. Kohler, Univ. of Tuebingen, “Globalization & Wages”, SS 2019 7

– Thus, in an open economy, factor incomes earned by domestic

individuals are no longer determined by domestic scarcity, but
by world-wide scarcity of certain types of the respective types of
factors (labor, capital)
– As we shall see, openness on factor markets is not necessary for
factor prices to be the same in all countries

• This implies that changes in the degree of globalization (openness of a

certain economy) must be expected to have an impact on inequality

• Technology comes in because it provides (and changes) the link between

goods (demand) and demand for different factors of production

• Distinction between income inequality and wealth inequality (we look

only at income inequality here)

• Long-run effects will typically be less pronounced than short-run ef-

fects:

– Very short run: workers and capital are “locked” into their re-
spective firms and industries
– Short run:
∗ workers may be reallocated between different firms in the
same industry; workers responding to pay differences across
firms
∗ workers may be reallocated between different industries, re-
sponding to pay differences across industries
– Long-run:
∗ Supply of workers with different skills etc. becomes endoge-
nous; educational efforts responding to pay differences across
different types of workers (high-skilled vs. low-skilled)
∗ Overall amount of capital and capital allocation across indus-
tries becomes endogenous, too

• Long-run reduction of inequality (convergence) or long-run trend of

increasing inequality?
W. Kohler, Univ. of Tuebingen, “Globalization & Wages”, SS 2019 8

1.3 A note on measurement

• General warning: measuring income inequality is among the most tricky
challenges of empirical economics. It is usually not a good idea in this
context to aim at the data, first thing and straight away. We therefore
do not start with looking at numbers, but it is worth mentioning some
of the often used concepts of measurement.

• Measuring personal income distribution:

– Gini coefficient: A single number indicating the extent to which the

income distribution deviates from complete equality. Suppose we
have 100 people. If total income is Y and each person earns Y /100,
this would be complete equality. In this case the poorest 1 percent
of the population (the poorest person) earns 1 percent of total
income, the poorest 20 percent earn 20 percent and so on. The
coefficient is normalized so that complete equality leads to a zero
value and the maximum deviation from complete equality (one
person earns all the income) leads to a Gini coefficient equal to
one. Complete equality means that the (cumulative) distribution
function for incomes in the population is uniform.
– A related concept is that of income percentiles. The first per-
centile is the income level at the 1 percent point of the cumulative
frequency distribution, i.e., the income level yp1 such that one per-
cent of the population have incomes equal to, or lower than yp1 .
The most famous income percentile is the median income. Other
percentiles often used are deciles, quintiles and quartiles. Ten per-
cent of the population have incomes equal to, or below the p10
decile yp10 , and so on. The first quartile income is yp25 , the income
that 25 percent (a quarter) of the population just achieve, or don’t
achieve. The second quartile, yp50 , is equal to the median income.
The quintiles are yp20 , yp40 ,and so on.
– Note that yp10 is not equal to the total, or average income of the
10 percent poorest.
– The percentiles do not contain any information on inequality, only
percentile ratios do. A ratio often used is the ratio yp90 /yp10 ; this is
the income reached or surpassed by the 10 percent richest people
W. Kohler, Univ. of Tuebingen, “Globalization & Wages”, SS 2019 9

(90 percent are poorer), relative to the income that the 10 percent
poorest either just reach, or do not even reach.

• Measuring functional distribution: All of the above measures focus

on the personal income distribution. The functional distribution looks
at incomes earned by different types of factors, rather than different
persons.

– Historically, the most widely used measure of the functional dis-

tribution of income is the wage share, the share of wage income in
aggregate income (gross domestic income, say), or the wage ratio,
the ratio of wage incomes to capital incomes plus profits.
– Conceptually speaking, in economics there is a big difference be-
tween capital income (capital rental), which is factor income on
the same footing as labor, and profit income which is non-factor
income (pure profits, due to imperfect competition).
– More recently, the policy debate has focused on what is often
referred to as the skill premium, the excess of wages for highly-
skilled (mostly defined as highly educated) workers over wages for
low-skilled workers.
– The idea of looking at different types of factors can be refined,
of course, to many different types of factors. One may, for in-
stance also look at different types of capital, or capital installed
in different sectors; see the specific factors model below.

• The two types of income distribution (personal, functional) are not

independent, of course. It is rather obvious that the functional dis-
tribution of income translates into a corresponding personal income
distribution, based on individual factor ownership.

• As we shall see, the functional distribution of income reflects the rel-

ative scarcity of different types of factors. Changes in this relative
scarcity drive changes in the functional distribution of income, which
translate into certain changes in the personal income distribution, de-
pending on individual factor ownership.

• Changes in the functional distribution of income (factor price changes)

also alter the incentives for factor accumulation. For instance an in-
W. Kohler, Univ. of Tuebingen, “Globalization & Wages”, SS 2019 10

crease in the skill premium means a higher incentive for skill formation
(education), leading to a change in factor ownership through time.

• In this course we deal with different theoretical models that highlight

certain determinants of the functional distribution of income. A large
part of the course will deal with determinants having to do with trade,
since globalization is seen as a potential cause of unwelcome trends in
the functional and, ultimately, the personal income distribution, which
matters most for policy makers (and voters).

1.4 Some numbers to start with

See the separate file with some graphs under ILIAS.
Also, see the syllabus.